October 21, 2019

“All we need is just a little patience”

Opportunity Equity 3Q 2019 Letter

“Little patience
Need a little patience
Just a little patience
Some more patience
Need some patience
Could use some patience
Gotta have some patience
All it takes is patience
Just a little patience
Is all you need”
-Guns N’ Roses

Opportunity Equity lagged the market in the third quarter, falling 1.81%, while the S&P 500 climbed 1.70%. The quarter illustrates well the frequency versus magnitude problem in investing. Despite beating the market for 2 of the 3 months (July and September), August’s sizeable setback proved difficult to overcome. If the quarter had ended on September 13, the Strategy would have done just that, actually beat the market for the quarter.1 This demonstrates another critical concept when assessing performance: the importance of start and end points. The quarter obviously did not end then, so the point doesn’t contain much significance.

Except, the point brings to mind what I view as one of the very biggest quandaries of investing: why do people focus so much on the short-term gyrations of the market when most investors’ time horizons can be measured in years or decades, rather than months or quarters? Behavioral finance sheds great light on why: recency bias (ability to remember the most recent events best/focus on the “now”), myopic loss aversion (losses are more painful than gains are pleasurable), availability heuristic (things easily recalled must be most important so whatever gains the most attention in the press is top of mind), mental accounting (classification of funds differently) and so on. The more important question is whether there’s anything we can do to get people to behave in a manner more conducive to building their wealth long term?

The current environment really highlights these issues. There’s an incessant focus on all of the “risks”: 10-year old bull market, trade wars, possible Fed error, political uncertainty, etc. Yet despite all of this, the market remains up roughly 20% year-to-date. Yes, we had a major sell-off in the fourth quarter of last year but if we look at the entirety of 2018 plus the 2019 year-to-date period, the market is up 15%, or 8.4% annualized. It certainly feels much worse given the volatility and constant focus on risk, but it’s really not!

I recently attended a presentation training class where we had to give many presentations (total shocker, right?). It was a small, diverse audience that wasn’t financially sophisticated. We had only a few minutes to prepare presentations, and another couple to deliver them. What did I tell them about investing? Investing is simple but not easy. You can make a lot of money over time abiding by a couple of simple rules: save and invest regularly (systematic monthly investing ensures you buy more at lower prices rather than the reverse) in a broad, diversified fund and focus on the long term. I informed the group that the market almost always goes up over the long term (5-10 year periods) so if we remain disciplined and patient, it’s actually relatively easy to do well.

When I got back to the office, I checked the updated figures on long term returns. If you look back to 1928, the market is up 88% of rolling 5-year periods and 93% of rolling 10-year periods. Those are high odds of success! The average and median 5- and 10-year annualized total returns are roughly 10-11% over the period.

I’m sure the “what-abouts” pop up in your mind. What about after such a strong period? The current trailing 5-year annualized return of 10.8% is pretty high, so does that mean we are more likely to do worse? I thought it might before looking at the data. When you look at only periods where the trailing return is 10% or more, the forward returns are actually higher (12-13%). Why? Basically, because that puts you in bull market regimes (like now) and excludes the big bear markets. I’m always amused when my data analysis confirms Bill’s broad points (here, emphasizing that we are currently in a bull market).

What about after a yield curve inversion, doesn’t that mean a recession is coming? Well, there’s not many yield curve inversions. The 1-year-10 year yield curve spread has the best predictive track record, but it only goes back to the 50s. Since then, there have only been 10 inversions. I was taught in Stats101 that you need a sample size of at least 30 for reliable inferences.

But people love patterns. Here they’ve found a reliable one and it even makes theoretical sense. I’m not arguing against the merits of it, as I believe it does contain some signal. Nonetheless, the conclusion is the same if you focus on the long term. After inversions, the market was up 80% of the time on a forward 5-year basis and 90% on a 10-year basis. Forward 5-year annualized returns average roughly 7-9%. The only time you lost more than 1% on a forward 5-year basis was after the top of the longest secular bull market in history (April 2000) when starting valuations were very expensive, unlike now. (historical S&P 500 P/E in our infographic) Even proponents of this cautionary tale admit that the average time before a recession is twelve months.

So here we may have a signal with a long delay before it’s likely to cause pain and the long-term outlook remains solid. For me, it’s way too hard to try to figure out how to use that to improve your returns. Selling now risks missing immediate upside and the possible pullback could merely bring you back to a level above current ones. It seems much easier and more sensible to just be patient and focus on the long term if your time horizon allows it.

While our feelings scream CAUTION, the facts tell a different story: be patient, focus on the long-term, buy more after inevitable pullbacks and invest in something you have the confidence to hold when things get shaky. The last part is important. I believe the most difficult part of investing is managing emotions that make us want to do the wrong thing at the wrong time, like selling after we’ve lost money, because we are afraid to lose more. Owning something you understand and have confidence in really helps you remain invested during troubled times.

I always find confidence in our companies. When things get scary, I go back to basics: what are the fundamentals of the businesses we own? Usually, there is plenty of reassurance to be found there. We own some great companies. Take a look at a few of our top holdings: RH, Amazon, and OneMain were the biggest positions at quarter-end. RH sells high-end home furnishings at scale. The company has a unique offering as there are no other scale, luxury furnishings players. It mostly competes against mom and pop shops. Scale allows them to do really interesting things. For instance, RH’s restaurants’ results have exceeded all expectations. They do well on their own but, more importantly, create a sought-after experience (who else in retail is doing that?) and heighten the brand. The stock has made us a lot of money (roughly 5x) as we bought when others were dumping it. It still trades at a discount to the market (16x this year’s earnings and 14x next). The business has great returns on capital and a large, long-term market opportunity. It’s just barely beginning international expansion. It is economically sensitive, but it continues to have attractive upside over the long term.

Amazon needs no introduction or explanation. It’s been our single biggest contributor to performance over the life of the Fund. It has a huge total addressable market (retail + software/cloud) with an “authentic business genius” (Warren Buffett quote about Jeff Bezos) at the helm. Growth inevitably slows as companies get larger, but Amazon is still expected to grow top line in the high teens/low twenties. It trades at only 17x EV/EBITDA for 2020. Guess who trades for more? Proctor & Gamble (growing 3%), Coca-Cola (people must not be that fearful about the decline of sugary drinks), Costco (great business, but it is growing at a fraction of the pace (7%) and arguably could be threatened sometime in the future by Amazon’s success). The point is: it’s one of the most amazing businesses in history and you can still buy it for less than many other companies. It’s a keeper.

OneMain provides subprime loans nationwide. OneMain’s loans often provide the only option for their customers who don’t have savings to cover some of life’s urgent and costly needs. While it charges high rates, they pale in comparison to the terrible alternatives of payday lenders or going without a critical need (like a broken furnace). Obviously, this type of business varies with the business cycle and incomes. The company has done a great job managing credit and has shifted the book towards secured loans, which provides more protection in a downturn. Valuation offers a large margin of error here. It trades for 5.6x this year’s earnings, which is only slightly more than half the typical 10x multiple of similar businesses. Arguably, the market is already pricing this as if earnings will dive into a recession. This creates a large opportunity if they don’t. The company recently initiated a dividend so you get paid a solid 2.9% while you wait for the market to come to its senses on this one.

I won’t bore you with details on every single holding, but I could. I love our portfolio. When things get crazy in the markets, I look at the fundamentals of our companies to remain sane. We expect these investments to pay off nicely over the long term. And the great news about the market swings and swoons: they create opportunities from which you can profit!

We added 2 new names in the quarter: Medifast and Peloton. We also exercised our ZioPharm warrants and were issued new warrants as part of a capital raise. Subsequent to quarter-end, we bought a lot more Stitch Fix too. We only exited one name: Mallinckrodt, which we rolled into our other names with opioid exposure where we have more confidence.

Medifast is a little known Baltimore-based health and wellness company. They’ve done a remarkable job growing the business from a few hundred million in revenues a few years ago to $750M this year after orienting the business around health coaches. They aimed to double the business in three years and accomplished it in two. Now they’re working on a plan to double revenues again. They’ve done all of this profitably while returning capital to shareholders. The stock peaked about a year ago at $260 per share and has fallen to around $99 weighed down by competitive concerns after troubles at WW (formerly Weight Watchers) and Nutrisystem, along with some headline-grabbing short reports and concerns about an ERP (enterprise resource planning software) implementation. At the current level, the company trades for just 14.5x earnings with 20%+ topline growth going forward and a 3% dividend yield. If it reaches its 2021 target, it’s trading for only 10x earnings out a couple of years. We believe Medifast has the potential to double.

The controversial Peloton story garnered many headlines. While the IPO priced at $29, the top of the range, it quickly fell 20% after bears came in. This one provokes strong feelings all around: bulls love it and bears despise it. As you can see, we fall more in the bull camp, although we admit that if the market really sours on unprofitable growth names, it could trade lower from here. What we love about it: Peloton users are more cult-like club than agnostic exercisers. The company focuses on wowing them and high net promoter scores along with sky-high growth suggest they succeed. Competitive concerns abound, but the bet is that the consumer brand power of Peloton is more similar to Apple than FitBit or GoPro. While the equipment is expensive, the zero-cost financing plan means the cost of ownership is comparable to a gym membership while usage is often better. While they continue to invest in growth, the company has already demonstrated the profitability of the model by achieving adjusted EBITDA breakeven. Now it’s ramping investment in other areas (treadmill and international growth). We believe the strong brand along with the launch of a lower-priced treadmill will fuel growth. We believe the stock has the potential to be up more than 50% from these levels.

Stitch Fix declined after announcing the quarter on disappointing profit guidance. This was a great opportunity for us to ramp the name. Katrina Lake and her team deserve credit for an amazing job so far. They’ve exceeded the targets they set out at the IPO, growing closer to 25% than 20% while generating profits and free cash flow. This is a company that grew a $1B business with $20M in venture capital. Most excitingly, the company announced a “direct buy” program where customers can buy items outside their regular “fixes” (shipments of apparel/accessories). This has the potential to greatly expand the addressable wallet share the company can access. Early test results are positive. Yet the company doesn’t price in any of this potential. The company trades for less than 1x sales and has the potential to compound capital at 20% for an extended duration in our view.

We hope you share our excitement in the portfolio and have the patience and confidence to profit with us in the future.

Samantha McLemore, CFA

Strategy Highlights by Christina Siegel, CFA

During the third quarter of 2019, Opportunity Equity returned -1.81% (net of fees) compared to its unmanaged benchmark, the S&P 500 Index, return of 1.70%.

Relative to the index, Opportunity was overweight the Consumer Discretionary, Financials, Health Care, and Industrials sectors on average during the quarter. With zero allocation to Energy, Materials, Real Estate, and Utilities, the Strategy was dramatically underweight these groups and more moderately underweight the Information Technology, Communication Services, and Consumer Staples sector. In terms of sector allocation, the overweight position in the Health Care sector, which underperformed the index, detracted the most from the portfolio’s relative performance. On the other hand, the underweight in Energy, which underperformed the index, contributed the most to relative performance.

We added three positions and exited two positions during the quarter, ending the quarter with 39 holdings, where the top 10 represented 42.7% of total assets compared to 21.6% for the index, highlighting Opportunity’s meaningful active share of 100.7%.

Top Contributors

RH (RH) increased 47.8% over the quarter after reporting 2Q results above pre-announced results and raising full year guidance again. The company reported 2Q earnings per share (EPS) of $3.20 above preannounced EPS of $2.65-2.72 and consensus of $2.68. Total sales increased 9.9% to $706.5M above guidance of $696-699M and consensus of $694.9M. The company raised their full year EPS guidance again to $10.53-10.76 from preannouncement guidance $9.08-9.52 with total sales growth of 6.8%-7.3% up from 6-7% previously. The company announced the pricing of $300M 0% convertible notes due 2024 at a 25% conversion premium to a closing price of $169.12. The company entered into a hedge to limit earnings dilution as a result of the convertible note issuance up to a 100% premium of the stock’s price of $169.12.

OneMain Holdings Inc. (OMF) gained 15.2% as they reported 2Q results which beat expectations. The company reported adjusted EPS of $1.62 versus $1.34 expected with 2Q net charge-offs (NCO) of 6.2%. The company declared a special dividend of $2/share. The company increased its outlook with net receivables at year-end 2019 expected to grow by 8-10% compared to 5-10% previously and with the NCO rate expected to come in at 6.1-6.3% compared to <6.5% previously. The company continues to benefit from lower rates as the company has been able to refinance and issue new debt at very favorable costs, while also extending the duration of its funding.

Genworth Financial Inc. (GNW) rose 18.6% as the company announced an agreement to sell its 57% controlling stake of its Canadian unit to Brookfield Business Partners LP for C$2.4B. The company hopes this will help push forward their merger with Oceanwide after agreeing to another extension of the deadline to November 2019.

Top Detractors

Mallinckrodt plc (MNK) continued to decline over the quarter, losing 73.8%, as opioid litigation continued to weigh on the stock. The stock drastically dropped after Bloomberg reported that the company had hired restructuring advisers, although nothing has come of it so far. The company then announced a settlement to resolve the track 1 opioid cases in two Ohio counties with a $24M cash payment and $6M in generic product donations. The company lost an appeals court bid to revive patent-infringement claims over Praxair’s generic version of INOmax. The company announced positive Phase 3 Data for both Terlipressin and Stratagraph over the quarter as well as positive read outs from their Phase 4 Acthar studies in MS and RA.

Quotient Technology (QUOT) lost 27.2% during the quarter after reporting mixed 2Q results and lowering guidance. Revenue came in at $104.7M above consensus of $103.8M and Earnings Before Income, Taxes, Depreciation, and Amortization (EBITDA) of $11.7M was below the Street at $12.7M. The company lowered full year guidance to revenue of $422-432M from $460-470M and adjusted EBITDA of $42-48M below $66-71M. The decrease is the result of lower spending from three large consumer packaged goods (CPG) customers and delays with new products. The company announced the completion of its stock buyback program with $60M in buybacks. Steven Boal is returning as CEO and board member Scott Raskin was named President.

Alexion Pharmaceuticals (ALXN) fell 25.2% over the quarter after reporting a top-line beat with revenue of $1,203M versus the Street at $1,174M and EPS of $2.64 ahead of consensus of $2.34. The company raised full year guidance with revenue of $4,750-4,800M from $4,675-4,750m and EPS of $9.65-9.85 from $9.25. Later in the quarter, the US Patent and Trademark Office said it would review three patents on its top-selling Soliris drug following a challenge filed by Amgen. The European Patent Office decided to refrain from granting Alexion two Soliris patents which would have provided patent protection through 2027. The company also announced the acquisition of an exclusive license to develop and commercialize BBIO’s/EIDX’s TTR stabilizer AG10 in Japan for $25M upfront, $25M equity investment along with milestones and royalties. Alexion announced the planned succession of CFO Paul Clancy with Dr. Aradhana Sarin M.D., who is currently Chief Strategy Officer, beginning in the fourth quarter.

For important additional information on Opportunity Equity strategy performance, please click on the Opportunity Equity GIPS Composite Disclosure. This additional information applies to such performance for all time periods.

Contact Miller Value Partners to obtain information on how Top Contributors and Top Detractors were determined and/or to obtain a list showing every holding’s contribution to Strategy performance.

The views expressed in this report reflect those of the Miller Value Partners strategy’s portfolio manager(s) as of the date published. Any views are subject to change at any time based on market or other conditions, and Miller Value Partners disclaims any responsibility to update such views. The information presented should not be considered a recommendation to purchase or sell any security and should not be relied upon as investment advice. It should not be assumed that any purchase or sale decisions will be profitable or will equal the performance of any security mentioned. Past performance is no guarantee of future results.